UBS On Munis: Closed-End Funds Still Cheap; Consider A Tax Loss

In its October municipal market guide, UBS says munis are "poised to perform a bit better in the near term" and notes that closed-end funds continue to trade at attractive discounts:

In the last four weeks, the municipal funds in our coverage universe have been up by an average of 2.5%. The increase has been in line with their net asset value returns and hence the discounts have not widened. Year-to-date the national leveraged funds are down 15% (market return) on average while their net asset values are down around 9%. National funds are now trading at a 6% discount to net asset value (NAV) and continue to be cheap versus a 1% discount on a 52-week average basis. Average yields on leveraged national funds hover around 7%. Our top picks are Neuberger Berman Intermediate Duration Fund (NBH) and BlackRock Muni Income Trust (BFK).

Here's UBS on Puerto Rico:

[I]ndividual state funds have higher exposure to Puerto Rico versus the national names. National funds have the ability to buy bonds across all states. By contrast, state funds are limited to purchasing bonds issued within their home state or from Puerto Rico and other US territories (i.e. US Virgin Islands and Guam). Therefore, some of the state funds like Neuberger Berman CA Intermediate Municipal Fund (NBW), BlackRock Muniholdings NJ Quality Fund (MUJ) and BlackRock NY Muni Income Trust (BNY) have higher allocations to Puerto Rico bonds in their portfolios. Overall, it appears that the funds we cover have limited exposure, national and California funds have on average 2% of their assets in Puerto Rico bonds. New Jersey and New York state funds have 3-4% on average.

The bond market sell off that occurred over this past summer has produced unrealized capital losses in many municipal bond portfolios.... Current US tax laws allow realized losses to off set gains realized with other investments. By realizing (harvesting) a capital loss to off set taxable capital gains, reported investment gains and tax liabilities decrease…. Investors may be able to lower their tax liability while shifting from underperforming securities to those securities better positioned for current market conditions and investment objectives.

And UBS says the municipal bond market has broadly "entered into a transitional phase":

Municipal bonds are no longer a "rates" product but rather one based on intrinsic credit worthiness. Recent events playing out in Detroit and Stockton have raised the ante for investors unaccustomed to assigning much risk weighting to that part of their municipal portfolios.

We do not expect municipal bankruptcies to become commonplace events, but we do expect an increase in the number of local governments seeking protection, particularly if Detroit's attempt to discharge pension liabilities is successful. As we look ahead, we expect conventional notions regarding the homogeneity of municipal bonds to dissipate. In such an environment... investors should consider the debt offered by established public enterprises as an attractive alternative to tax-supported bonds. Major commercial airports are an excellent example of such an enterprise and have the added benefit of offering a greater level of protection from general fund distress.

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